09model10/6/2009 8:1612/2/2002Chapter 9. Model for evaluating the cost of capitalThe cost of capital is a vital element in the capital budgeting process. For a project to be accepted, it mustprovide a return that exceeds its cost of capital, or hurdle rate. The cost of capital also serves three otherpurposes: (1) It is used to help determine the EVA, (2) Managers use the cost of capital when deciding betweenbuying and leasing, and (3) the cost of capital is used in the regulation of electric, gas, and telephone companies.The cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firmuses to finance its assets, or its WACC. There is an overall, or corporate, WACC which reflects the averageriskiness of all the firm's assets. However, since different assets may have more or less risk than the average,the overall WACC must be adjusted up or down to reflect the riskiness of different proposed capital budgetingprojects.The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest. The after-taxcost of new debt is calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate.PROBLEMFind the after-tax cost of debt for a company that pays 10% interest on debt and is subject to a 40% marginal taxrate.10%Tax rate40%6%The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if itissues new preferred stock. No tax adjustment is necessary, as preferred dividends are not tax deductible.PROBLEMWhat is the cost of preferred stock for a company that pays a preferred dividend of $10 per share if the companycould sell new preferred for $97.50 per share?Pref. Dividend$10.00Pref. Price$97.5010.26%There are two sources of equity capital, common stock and retained earnings. Since there are no flotation costsrelating to raising retained earnings, the cost of retained earnings is simply an opportunity cost equal to theThe cost of equity raised by issuing new common stock is higher than that for retained earnings because offlotation costs. Several procedures can be used to find the cost of retained earnings, including the CAPMapproach which was introduced in Chapter 5, the DCF approach as introduced in Chapter 8, and a risk premiumapproach based on the discussion in Chapter 5.The CAPM ApproachRecall, that the CAPM equation was that of the Security Market Line. The required return of a stock, or in thiscase the cost of equity, can be determined using the risk-free rate, market risk premium, and the stock's beta.COST OF DEBT, kdB-T kdA-T kdCOST OF PREFERRED STOCK, kpkpCOST OF EQUITY FROM RETAINED EARNINGS, ksreturn investors expect to earn on the firm's stock, or ks.

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